When Workers Know Exactly How Much More Money CEOs Make, Will Anything Change?
A new disclosure rule banks too much on the power of transparency.
The debate over whether America’s CEOs are overpaid is rich in data and poor in context. In an annual rite, newspapers compile lists of the previous year’s highest-earning executives, think tanks compute just how much more CEOs make than the average worker, and then both sides of the debate use those standalone figures to serve their purposes: Workers who struggle to pay their bills can’t imagine how their time could be worth so much less than someone else’s, while business leaders and corporate-governance professors remain convinced that executives, like movie stars or professional athletes, have specialized skill sets that deserve tremendous compensation.
Five years ago, when Congress passed the Dodd-Frank Act, it decided it knew just what the debate needed: more numbers.
One part of the regulations laid out by Dodd-Frank was that the SEC would enact a rule intended to increase the transparency of executive compensation. The rule, finalized on Wednesday, will require about 3,800 publicly traded companies to say how much they pay their CEO, how much they pay their median worker, and the ratio between those two numbers. Those figures will begin appearing in headlines and think-tank reports in a couple years, when companies will be required to start reporting them.
Will the rule be effective in publicly shaming companies, as is the apparent intent? It could be, but public shaming has its limits. The U.S. has been requiring companies to reveal how much they pay their CEOs since the 1930s, and CEO pay continues to soar even with that transparency. The Economic Policy Institute, a left-leaning think tank, calculates the current CEO-to-worker pay ratio to be in the neighborhood of 300:1; in 1978, it was 30:1. Previous efforts to reduce executive compensation have been “based on the assumption that those who had asked for that kind of money were capable of that kind of embarrassment,” Charles Elson, a professor at the University of Delaware told The Washington Post. “And they weren’t.”
But the bigger problem is that the ratio isn’t very useful in the first place. “The bottom line is that this is one of the sillier and more pointless disclosures that I have ever seen,” David Yermack, a professor of finance at NYU’s Stern School of Business, told me.
Why is that? As Kevin Murphy, a professor of finance at USC’s Marshall School of Business, explains, it’s not a useful yardstick across companies. “Ironically, the ratio will not be as high for Goldman Sachs and other firms where the median ‘worker’ is a highly paid professional—for example, Goldman will have a lower ratio than JPMorgan Chase, because the latter has commercial banks and the median worker is likely a teller,” he says. Similarly, ratios could look very different for fast-food companies than they will for tech companies, or banks, or media conglomerates.
And the reason that the SEC usually issues disclosure rules—to help investors make trading decisions—hardly applies here. The pay ratio could turn out to be some unexpectedly reliable indicator for company performance, but it most likely will not.
Of course, the reasons that some people and organizations stake their faith in the new rule are not all bad. Labor advocates say it’s a good thing that workers can glance at a publicly available document and see how their company stacks up. (However, it is not fully clear how much this differs from the current situation, in which a CEO’s pay is publicly disclosed and workers can easily compare it to their own.) And the strategy of public shaming isn’t entirely without merit—consumers seem to care. A paper from researchers at Harvard Business School found that a company with a 1,000:1 CEO pay ratio needed to charge 50 percent less for its products in order for consumers to view them as favorably as full-price products from a company with a 5:1 ratio, when that information was visible.
One thing that the supporters of this rule are right about is that companies and pro-business lobbyists are likely exaggerating how much it will cost to comply with some parts of the rule, according to Michael Ohlrogge, a Ph.D. candidate studying management science at Stanford. It may be burdensome for some companies to conform to in its first year—when large companies tabulate the compensation of all their workers, including those overseas and at their subsidiaries—but the costs will drop significantly after that.
Ultimately, the ratios that companies will disclose in their SEC filings will not be grist for meaningful debate so much as fodder for shocking headlines. Individually, factoids about executive compensation can be truly, deeply bananas, and some media outlets capitalize on that. “The ratio information will certainly give newspapers and magazines the opportunity to run a new set of articles about CEOs with the highest pay ratios and CEOs with the lowest pay ratios,” says Joseph Grundfest, a professor at Stanford Law School. The first round of disclosures may spawn a batch of urgent thinkpieces, but it’s unclear how they will change the complexion of a conversation that has decades’ worth of similar data.
Executive compensation hasn’t changed much after disclosure requirements, “say-on-pay” rules that put up CEO pay to nonbinding shareholder votes, or even the financial crisis. What might work instead? Yermack, the NYU professor, has one big-picture idea. “I think the solution lies in making the median worker more productive through better education and training, an area where the U.S. has not been particularly successful,” he says. “We are very good as a country at educating high-skilled workers for elite jobs, but we do not do nearly as well as other countries in education people in the broad middle of the labor market.”
Lynn Stout, a professor at Cornell Law School, has another proposal—a more specific one. In Stout’s view, the rise in CEO pay can be attributed to a change in the tax code back in 1993. After the change, in order for companies to be able to keep deducting executive pay as a business expense, they had to tie compensation to a measurable metric. They settled on some proxies for shareholder returns. “Executives, in an odd way, were given control over their own pay because all they had to do was do their best to manipulate whatever the metric was,” she says.
“If you want to know why executive pay is skyrocketing, it's not because of lack of shame, it's because of this change in the tax code,” Stout maintains. Her solution, then, is to have a rule stating that no company can deduct executive pay exceeding 100 times the federal minimum wage. And she says it has an added perk: “It will finally give the business roundtable a disincentive to fight increases in the minimum wage.”